I’m an investor with New Atlantic Ventures, where I help launch early-stage companies that have new technologies and new takes on how to win in business. I’m inspired every time entrepreneurs prove there’s a better way to solve big problems, make life better or disrupt comfy clubs. I'm skeptical, however, when start-ups get too trendy or raise too much money before the business is proven. Before becoming an investor, I had a great run building Boston Consulting Group’s Technology, Media, and Telecommunications Practice. Away from work, I ski, mess around in boats, spoil my grandchildren, and tinker with digital toys.

Tough Truth About Defensive Exits

A few weeks ago I was talking with a co-investor in a company that is missing its numbers seriously, and he said, “Let’s just sell this thing!” I often have that urge too, when progress is slow and cash keeps burning.

Sisyphus: Greek king condemned to perpetually push a rock up a hill. Image from the Prado Museum via Wikipedia.

But, experience teaches that a company in this condition — burning cash and far from breakeven — is likely to be worth shockingly little, or even nothing, if investors try to force a sale. There can easily be only bottom-feeder offers, or no offers at all. Selling can be a Sysiphean task.

Why? Several reasons:

A lot of early stage companies are out there seeking to be sold. VCs fund 1,500-2,000 new companies every year, and angels fund about 60,000. But, there are only ~500 reported exits per year recently. So tens of thousands of VC/angel-funded companies are looking for exits. Buyers can be very selective.

Buyers usually want companies that will add to earnings within a year (“accretive”) and which are big enough to make a difference, which means revenues of $25 – $100 million plus.

For a smaller, earlier company that has a promising product, enthusiastic users, but little revenue, buyers will ask themselves: “Why not just build the product, now that we see what it is?” Application development costs less today, and this approach produces a product that is well integrated with the platform and can be rapidly rolled out to the user base.

There are of course examples of pre-revenue companies bought for large amounts, like Instagram. These events are extremely rare. Better to count on winning Megabucks.

Plus, the exit process is often slow, frustrating, and expensive. Buyers’ BusDev teams are very busy: it takes months to get in front of them, and more months to get an organization engaged and an offer approved at the top. External events can disrupt this process. You need to keep funding normal operations, because that is what you are trying to sell, and the banker’s retainer is ticking away.

Finally you have your signed offer. The celebration is brief, as that’s when the negotiation of definitive agreements (“definitives”) starts. A wise colleague says: it only gets worse from this point. Buyers normally demand an exclusivity agreement that prohibits the seller aiding or encouraging any other potential buyers for typically 60 days. So you have no clear alternative to getting the agreed deal closed.

Here are some of the gambits aggressive buyers use (and most buyers are aggressive):

The buyer performs detailed due diligence and claims to find undisclosed issues that justify lowering the offer. This happens more often than not. Recently a buyer said this and lowered the offer 50%. We asked, “What is the problem.” He responded: “I don’t know; I haven’t read the due diligence report yet, but I’m sure I’ll find something.” (No exaggeration.)

The buyer imposes economically onerous terms in the definitive agreements (“definitives”). My favorite: the buyer demands indemnification for intellectual property issues that arise after the escrow is released, for five years, up to the full amount of the proceeds. This means investors need to maintain reserves against potential claims and cannot distribute all of the proceeds.

Buyers delay closing while they fiddle around with the deal structure to optimize tax effect for their benefit, etc., etc.

You might be thinking: stop kvetching! Work out what to do. Here are my suggestions:

Focus on getting companies like these to breakeven, even at a modest level of revenue. There is much more demand for companies that do not bring a burn rate with them. More important, a profitable company has time on its side to cultivate a favorable offer. In the last two years two profitable portfolio companies received offers and then were abused by buyers as above. They walked from the offers and sold successfully later for decent prices. Two other companies that were on month-to-month bridge financing were traded down 30%-50% during the closing process.

Cultivate business relationships with potential acquirers. A valuable business relationship makes a good offer more likely, and abuse less likely.

Obviously, find multiple offers. Two offers are far more than twice as good as one.

Face the facts and be realistic about exit value from the start. Buyers will ask or guess what you are expecting before they engage. If the number is too high, many will just walk away rather than waste time. If you shoot for an aggressive number, y0u can spend a long time and come up with no offers, having turned off potential offers at a realistic value. Much like a house, if you want to sell it, price it to sell.

In the negotiation of definitives, focus on the issues you know will be most onerous from the start. In a recent exit we focused on the IP indemnification, and succeeded in limiting the seller’s liability to the escrow.

Finally, if a company is small and it’s burn rate is significant, think very seriously about selling it back to the entrepreneurs. We’ve sold companies’ stock back to entrepreneurs for $1 and a right to participate in an exit that occurs in the next 12-18 months. If they can find a buyer, we get something back. If not, we avoid funding the burn and the banker fees and put our time on more promising companies, and we are probably well ahead to have done so.

I actually enjoy the exit process: it is challenging and dramatic, and you usually get paid at the end. But you have to know when you have something worth selling, and when you cutting losses is the right investment decision.

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